Spain Doubles Down on Austerity

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Amid rising Spanish borrowing costs and fears over the solvency of the eurozone's fourth-largest economy, the government of Spanish Prime Minister Mariano Rajoy on September 27 unveiled a new budget for 2013 (NYT) that includes a host of spending cuts and tax increases. The move is expected to pave the way for Spain to request formal financial assistance from the European Union, while benefiting from the European Central Bank's unlimited bond-buying program. Arresting the eurozone sovereign debt crisis before it engulfs Spain is crucial to ensuring the crisis remains manageable, argues Megan Greene, director of European economics at Roubini Global Economics. "If the crisis does spread fully to Spain and Italy, we could well see cascading sovereign and bank defaults across the eurozone--and a complete unraveling of the common currency area," Greene says.

Can you provide an overview of the eurozone crisis as it pertains to Spain?

Spain's crisis started off primarily as a banking crisis, much like that in Ireland. But because the banking and sovereign loop has gotten so tight, all of the bank recapitalizations have been foisted onto the state balance sheets. As the government has struggled to meet fiscal targets set up by the European Commission, Spain has undermined its own growth by implementing austerity measures. Consequently, now, it's also in a fiscal crisis.

As investors have gotten worried about Spain's solvency, borrowing costs for the state have increased. Foreign investors have all pulled their capital out of the country; so [Spain is] facing a balance of payments crisis.

What are the main takeaways from Spain's 2013 budget?

It has completely unrealistic general government budget targets. The Spanish government is going to have to retrench even further and implement more austerity measures in order to hit its deficit targets. I don't think it's at all realistic that it will hit even this year's target, which is a budget deficit of 6.3 percent of GDP. That's already been loosened from a budget deficit of 5.3 percent of GDP previously. So, if Spain misses this year's target, then that means next year's target will require even more austerity measures and structural reform. Of course, austerity measures and structural reform help in the medium to long term, but really serve to undermine growth in the short term.

Spain was hoping to announce a very strict budget so that they could meet all of the country-specific recommendations from the European Commission. Therefore, when they do ask for official support [a financial bailout], which comes with conditionality, no tougher conditions will be imposed on Spain. The prime minister has been pushing off asking for official assistance in the hopes that when he does go after assistance, he can assert that Spain has done all of this on its own volition and hasn't ceded sovereignty to Brussels, or to Berlin, just as importantly. The response from the European Commission to [the September 27] budget announcement was positive, and it does seem that this might pave the way for Spain asking for some official assistance from the EU bailout fund and then from the ECB.

What kind official assistance is Spain likely to request? Does it need a full sovereign bailout along the lines of Greece, or does it just need to request official assistance to be a beneficiary of the ECB's new bond-buying program?

It could ask for assistance in the form of some bond-buying in the primary market by the EU bailout funds, and then ECB assistance through its OMT program--a partial bailout that will buy Spain some time.

It depends whether you think Spain has a liquidity or a solvency problem. It could ask for assistance in the form of some bond-buying in the primary market by the EU bailout funds, and then ECB assistance through its OMT [Outright Monetary Transactions, or bond-buying] program--a partial bailout that will buy Spain some time. But it won't avoid Spain having to ask a full troika program [a sovereign bailout from the IMF, European Commission, and ECB], with Spain no longer borrowing in the markets at all and being fully supported by the official sector, which I think could happen as early as next year.

What are the political implications of the Spanish situation?

I think social unrest is going to become the new normal in all these first-world countries that are trying to undergo an internal devaluation. For the Spanish government, Prime Minister Rajoy has seen his popularity fall significantly over the past couple of months. Once he's the prime minister who has brought things to the arms of the troika, I think we can expect his popularity to fall even further, and that will make it even more difficult for the Spanish government to push through really unpopular structural reforms like labor market reforms. There's a lot of vested interests that are opposed to them--the trade unions--and having a government with very little popularity makes it more difficult for the government to shove through these difficult structural reforms.

An audit of the troubled Spanish banking sector is set to be released September 28. What's to be expected from that, and what does it mean for the recently agreed-upon EU loan for Spanish banks?

An independent auditor will release the results of a set of stress tests it's run on Spanish banks on a bank-by-bank basis to see what the recapitalization needs of the Spanish banks will be. One hundred billion euros of the EU bailout fund have already been earmarked for the Spanish banks. Most estimates suggest that the independent auditors will announce that Spanish banks together need around 50 to 60 billion euros in recapitalization. That figure will be a lot higher in reality by the end of this crisis, so I would put an estimate at above 100 billion euros, and possibly as high as 250 billion euros. Some of the assumptions involved in the stress test will include assumptions about property prices and property values, because of course the banking sector crisis in Spain was really sparked by a collapse in the property sector. The property sector hasn't hit a bottom at all; prices probably have about 20 percent further to fall. So in terms of recovery value, things stand to get a lot worse before they get any better.

How does what's happening in Spain relate to the rest of the eurozone? If Spain is forced, as you say, to request a full bailout from the troika, what kind of ripple effect could that have?

Spain is really the gateway for the crisis to go from being sustainable and manageable to being complexly unmanageable.

Spain is significant in that it is so big. To bail out Spain and support it fully so that it doesn't have to borrow in the markets requires a couple hundred billion euros. Also, investors haven't really discerned between Spain and Italy, which is another huge economy. When Spain does get some official financing, all eyes will turn to Italy next, and the bailout funds available are not big enough to bail out both Spain and Italy. So we could see both Spain and Italy pushed from having a liquidity problem to insolvency, and if that's the case, there just are not enough bailout funds to try to take them both out of the markets for any meaningful period of time.

Spain is really the gateway for the crisis to go from being sustainable and manageable--when it only had reached the smaller countries of Greece, Portugal, and Ireland--to being complexly unmanageable. If the crisis does spread fully to Spain and Italy, we could well see cascading sovereign and bank defaults across the eurozone--and a complete unraveling of the common currency area.

We will see Spain and, eventually, Italy, have to ask for official financing. There's not enough official financing to take Spain and Italy out of the market entirely. There is official financing available to help support Spain and Italy for a few years--to provide enough loans to buy up some of their debt while the ECB is also buying up some of their debt. That's just a time-delaying mechanism--it doesn't fundamentally solve anything--but it does buy some time for them to implement these structural reforms, have those structural reforms in place, and have them start to support growth, rather than undermining it.

While there has, as you said, been a sense of temporary relief, what are the medium- and long-term steps that need to be taken at both the national and European levels to rein in the crisis?

To actually draw a line under the crisis at the European level, we have to see one of three things. The first is growth--I expect the eurozone to remain in recession on average for the next couple of years--but if we have a huge depreciation of the euro, parity with the dollar, a significant relaxation of the fiscal target, a massive amount of quantitative and credit easing coming from the ECB, stimulus measures coming from the core countries to the first-world countries, then you could see the recession bottom out.

The second thing to draw a line under the crisis would be debt monetization. You could argue that the ECB's OMT program is a form of debt monetization, and it is. But it is limited to the short end of the yield curve, so it's not an unlimited form of debt monetization, which we would need to see [to] give countries time to address these types of crises.

The third thing would be debt mutualization that could come in the form of euro bonds, where debt is joint and is not really guaranteed. The euro countries haven't formally agreed on that as the best endgame, so actually finding a clear and credible roadmap toward achieving that is a long way off.

Everybody is playing the local politics game and wants to be reelected, and so these governments haven't managed to shove through these structural reforms yet.

On the national level: Eurozone policymakers, we've seen throughout this crisis, have excelled at kicking the can or buying more time. The whole point of them buying time is for countries to have the breathing space to actually implement structural reforms, to open up labor markets, and to make it easier to do business in these countries. So far across the board, with the exception of Ireland, we've seen a lot of legislation of structural reform, but we've seen very little implementation because they're very unpopular. Everybody is playing the local politics game and wants to be reelected, and so these governments haven't managed to shove through these structural reforms yet. But that's what we need to see for these countries to find sustainable growth within the eurozone. The alternative, of course, is for these countries to exit the eurozone, reissue their national currency, have it devalue massively, benefit from a nominal devaluation, and return to growth much more quickly.